335 Working Papers Why Prudential Regulation Will Fail to

ISSN 1518-3548
Why Prudential Regulation Will Fail to
Prevent Financial Crises. A Legal Approach
Marcelo Madureira Prates
November, 2013
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335
ISSN 1518-3548
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n. 335
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Why Prudential Regulation Will Fail to Prevent
Financial Crises. A Legal Approach
Marcelo Madureira Prates
The Working Papers should not be reported as representing the views of the
Banco Central do Brasil. The views expressed in the papers are those of the
author(s) and do not necessarily reflect those of the Banco Central do Brasil.
Abstract
Properly regulating the financial system is not an easy mission,
especially if the underlying intention is to prevent financial crises.
At the first part of the paper we suggest that the difficulty of
regulating the financial system results not only from its nature and
dynamics, but also from the process of creating rules itself.
Besides, we stress the complexities regarding the enforcement of
financial regulation, particularly in a setting of overregulation. We
point out some of the troubles that the financial system supervisors
may face in doing a proper oversight of all the institutions that
matter and also in searching for the right measure to punish the
institutions that fail to observe the relevant rules.
At its second part, we advocate that, to overcome the difficulties
and hazards related to the challenging duties of regulating the
financial sectors and enforcing the related rules, more attention
should be paid to the consequences of financial crises, not to their
causes, although it may seem counterintuitive at first sight.
We firmly believe that more important than organizing the best
possible prudential regulation is having a solid and well-developed
financial safety net. This could be done by answering at least three
main questions: (a) how to organize a deposit insurance and
resolution fund to be used as the first response to a problem in the
financial system; (b) how to find a private solution instead of a
public one when it comes to deal with failure in the financial
system; and, very important, particularly to reduce the moral hazard
that may follow the safety net, (c) how to hold executives
personally liable for the losses caused by failed financial
institutions.
Building a strong safety net might not only boost confidence in the
financial system and contribute to its stability, but also create the
right incentives to avoid reckless risk-taking, mainly if there are
rules establishing that other financial institutions, creditors and even

The author is grateful to Leandro Novais, Dulce Lopes, Flávio Roman, Cassiano Negrão, Cristiano
Cozer and Jefferson Alvares for their suggestions and comments.

Attorney at the Central Bank of Brazil. Master’s Degree in Constitutional Law and Administrative Law
(University of Coimbra, Portugal, 2004).
3
executives could be held responsible for the trouble caused by any
failed financial institution.
Keywords: financial crisis; prudential regulation; overregulation;
banking supervision; safety net.
JEL Classification: G01; G28; K23; K42.
4
“If men could learn from history, what lessons it might teach us! But
passion and party blind our eyes, and the light which experience gives
is a lantern on the stern, which shines only on the waves behind us!”
Samuel Taylor Coleridge
1. Introduction
In light of the recent financial crisis, which seems to be far from its end, too
much has been said regarding the regulation of the financial sectors. A lot of writings in
blogs, sites, newspapers, magazines and journals, specialized or not, call for more
regulation1, although dissenters still exist2.
Despite all the fuss, it looks like everybody is concerned only with creating new
rules, which is just the first part of the regulation process. Few people seem to be
worried about how these rules will be enforced and what the consequences will be if
they are not observed or even fail, again, to meet their ends. In fact, enforcement seems
to be a hidden side of financial regulation nowadays.
It is also interesting to stress that economists are by and large the ones thinking
over financial regulation, although creating and enforcing rules are essentially a legal
matter3.
That is why in this paper we propose to discuss the subject from a legal
perspective. In the first part, we will talk about the difficulties in regulating the financial
system, underlining some practices that may contribute to the ineffectiveness of
financial regulation.
We will also stress the complexities regarding the enforcement of financial
regulation, pointing out some of the troubles that the financial system supervisors may
face not only in doing a proper oversight of all the institutions that matter, but also in
searching for the right measure to punish the institutions that fail to observe the relevant
rules.
Trying not to emphasize only the difficulties and hazards related to the
challenging tasks of regulating the financial sectors and enforcing the related rules, we
will make some suggestions at the end of the paper, indicating a possible solution to
1
See, e.g., Crotty, 2009; Dagher and Fu, 2012.
See, e.g., Greenspan, 2011; Howard, 2011.
3
See Embid Irujo, 2009, pp. 21-22.
2
5
have an effective financial regulation, especially if the goal is to prevent financial crises.
Again, the legal approach will prevail.
In short, the basic question that motivates this paper is: will prudential regulation
be able to prevent financial crises? We dare saying that, from a legal point of view, the
shorter and more direct answer is ‘no’. Let us explain our reasons.
2.1. The difficulties in regulating the financial system
The first reason for being pessimistic about the effectiveness of financial
regulation is intrinsic. The financial system is inherently unstable, given that the
multiplier effect is in its origin and financial leverage is an inevitable part of its
development4.
It is important to recall that the banking system, a core part of the financial
system, is built on confidence5. In order to meet reserve requirements, banks are
required to hold only a part of the money they receive from depositors, being able to
lend all the rest. Consequently, they always owe more money than they actually hold in
their vault. Besides, banks face maturity mismatch between liabilities and assets, once
they use short-term borrowing to finance long-term assets6.
In normal times, the risks posed by these issues are manageable and confidence
remains steady. But in times of distress, when depositors want to withdraw all their
money simultaneously but banks’ reserves are insufficient and banks’ assets are illiquid,
confidence ruins, overwhelmed by reality.
It is worthy quoting John Kenneth Galbraith on this matter:
The world of finance hails the invention of the wheel over and over again,
often in a slightly more unstable version. All financial innovation involves,
in one form or another, the creation of debt secured in greater or lesser
adequacy by real assets. This was true in one of the earliest seeming
marvels: when banks discovered that they could print bank notes and issue
them to borrowers in a volume in excess of the hard-money deposits in the
4
It is interesting to note that the instability caused by maturity transformation is also central to Ricks’s
concerns about current and proposed financial regulatory frameworks. Nevertheless, Ricks advocates an
approach to it that is different from the one supported in this paper.
5
See Lastra, 1996, pp. 69-72. It is worth noting that money itself is built on confidence. See Simmel,
2004, pp. 173-178; Cozer, 2006, pp. 93-97 and 135-137.
6
See Lastra, 1996, pp. 78-83.
6
banks’ strong rooms. The depositors could be counted upon, it was believed
or hoped, not to come all at once for their money. There was no seeming
limit to the debt that could thus be leveraged on a given volume of hard
cash. A wonderful thing. The limit became apparent, however, when some
alarming news, perhaps of the extent of the leverage itself, caused too many
of the original depositors to want their money at the same time. All
subsequent financial innovation has involved similar debt creation
leveraged against more limited assets with only modifications in the earlier
design. All crises have involved debt that, in one fashion or another, has
become dangerously out of scale in relation to the underlying means of
payment.7
All the above said had the solely intention to stress that the financial system is
naturally unstable. Instability, speculation and, therefore, risk are parts of its origin and
development8.
No regulation will ever be able to change this reality, unless a law is passed, for
instance, setting the reserve requirements in 100% and prohibiting leverage. But this
solution would mean destroying the existing financial system and creating a ‘new’ one,
almost based on barter. No such proposal would be taken as a viable alternative, even
though something like it has been sincerely advocated recently9.
Remarking that rules cannot modify reality is important to stress that regulation
is nothing but organizing and controlling by restriction or incentive10. Regulation does
not have the intention of transforming the regulated fact or activity into something else.
Its aim is to limit or to stimulate a fact or an activity because they are relevant not only
for their stakeholders, but also to society. And its main boundary is respecting the
essence of the fact or activity regulated, even if the regulation involves the “attempt to
alter the behaviour of others”11.
Hence, financial regulation should not be created with the intention to turn the
financial system into something it is not, a stable and risk-free environment. Every
7
Galbraith, 1993, pp. 19-20.
See Galbraith, 1993. See also, Kindleberger, 2005 and Reinhart and Rogoff, 2009,
9
See Chamley and Kotlikoff, 2012. The two economists at Boston University advocate the creation of a
“limited purpose banking”, by transforming all banks in “mutual fund holding companies that do one
thing only – issue 100 per cent equity-financed mutual funds”. See also Cochrane, 2013.
10
For a survey about the concepts and definitions of ‘regulation’, see Black, 2002.
11
See Black, 2002, p. 20.
8
7
proposition intended to limit instability and risk in the financial system poses the danger
of disfiguring it instead of only regulating it.
But even if it were possible to proper calibrate rules and limit the characteristics
of the financial system without transfiguring it, there would be another problem: its
dynamics. And here we have the second reason for being pessimistic about the
effectiveness of financial regulation.
Facts precede rules: ex facto oritur jus12. Rules depend on facts and are created
to regulate these facts, either to organize, control or limit them, or just to transform
them into a legal matter, giving them legal consequences.
Consequently, it is important to observe that, on the one hand, rules do not
predict or anticipate facts, because rules always come after facts. And, on the other
hand, during the time some facts go unnoticed by legislators, they are unregulated, i.e.,
they do exist, they generate consequences, but not legal consequences, since no rule
deals with them.
Taking these basic legal principles to financial regulation, we have that rules
cannot limit creativity of financial markets or try to anticipate what new financial
instrument will be created, in order to control the risks involved13.
Rules are a response to a perceived reality. It takes comprehension and time to
create appropriate rules and still more time to pass the correspondent legislation or to
propose the related regulation. But few sectors, if any, are as frantic as the financial
sectors, which makes it hard for financial regulation to catch up with financial
innovation14.
Of course there are other innovative sectors subject to strict regulation, in which
a governmental authorization can be demanded before any innovation comes to market.
Take pharmaceuticals, for instance. Almost every laboratory has a technical staff
researching new and revolutionary drugs. But prior to receive authorization to be sold to
the public, these drugs have to be tested several times, even in animals and human
beings, for many years. Take also aviation. Planes are thoroughly projected, modeled
and tested for many flight hours before they can be sold to airlines. Besides, in aviation
the goal is to eliminate all possible risk, something not feasible in the financial system.
12
See Reale, 1993, pp. 197-201.
Contrary to this idea, see Embid Irujo, 2009, pp. 23-24; and also Conti, 2011, pp. 10-12.
14
See Greenspan, 2011; Conti, 2011, pp. 11-12 and 14.
13
8
Here is the difference: it is impossible to duly test financial instruments before
they hit the market, although something alike has been suggested15. The financial
sectors are similar to no other because it is not possible to simulate real conditions
unless a new financial instrument is actually put in an existing market in a specific
country. There is no such a thing as a proxy financial market.
And the consequences of using new financial instruments are so unpredictable
that even a big player like JPMorgan may face billionaire losses in its trading operations
without being able to properly explain them and long before regulators noticed what
was going on in its London offices16.
So, financial rules are thought and created today taking into account the
financial reality of yesterday, because a rule issued now cannot intend to regulate a
financial instrument or situation that does not exist yet.
But even if this time barrier could be removed, regulators would face another
dilemma, because every time they focus on a fact or activity, they immediately arouse
the attention of the regulated institutions, which begin the race to find ways to get
around the regulation17.
Trying to avoid these problems by creating rules only with goals and principles
is not a solution18. First, rules like those do not clearly state what is permitted and what
is forbidden, making hard to assess compliance in these cases and creating many
grounds for dispute. Second, such rules give a lot of discretionary power to supervisors,
transferring a task that should be performed by legislators – defining the right and
wrong – to unelected bureaucrats. Legal uncertainty is a result in any case19.
Making specific rules in order to micromanage every detail of a given fact or
activity is not a solution either. The reason is simple: overly descriptive rules create
many loopholes that can be easily exploited to game the regulation. Even a minor
renaming could create a new situation that evades many regulation’s definitions20.
15
See Posner and Weyl, 2012. Agreeing with the idea that new financial instruments should be tested and
put through small trials, see the interview given by Stephen Cecchetti, head of the monetary and
economic department of the BIS, to The Wall Street Journal on 30 Oct. 2012.
16
Regarding the billionaire losses of JPMorgan and their consequences for banks and regulators, see
Schwartz, 2012. On financial innovation, see the Special Report from The Economist, 25 Feb. 2012.
17
See “Buttonwood: Rover the Regulator”, 2012.
18
Note that this solution is proposed, e.g., by Howard, 2011. Although we differ with the author on this
matter, we do agree with his diagnosis, as we will remark below.
19
On the difficulties of having a “principles based regulation”, see Black, 2010.
20
See Black, 2010, pp. 11-12.
9
That is why we think the problem is not that the financial system is or has
become “too complex to regulate”21. The difficulty of regulating the financial system
results not only from its nature and dynamics, but also from the process of creating rules
itself. It is, in fact, a matter of too unstable, too inventive and, especially, too swift to
properly regulate.
But even if complexity were the only or the main cause making it difficult to
regulate the financial system, the problem would not be solved by simplifying financial
instruments and institutions22. You cannot just ask for a company, any company, to
simplify its business so you can understand and, therefore, regulate it23. As we have
said, regulation cannot and should not have the purpose to transform the regulated
activity into something else.
Let us not be fooled: properly regulating the financial sectors was, is and always
will be a difficult mission, especially if the underlying intention is to prevent financial
crises. And now that deregulation is out of question, being almost unanimously
considered the cause of the present financial crisis24, more regulation has been adopted
as the most likely response to deal with the fear of other crises25. More regulation,
however, does not appear to be a good answer, particularly if it comes as
overregulation26.
2.2. The perils of overregulation
Diminishing the regulatory burden, asking supervisors to step back and trusting
the financial sectors to refrain themselves proved not to be the best way to regulate the
financial system.
As the lack of rules is considered to be in the origin of the recent financial crisis,
asking for more rules is one of the inevitable reactions, if not the first and more
poignant27.
21
See Hu, 2012.
As proposed, e.g., by Johnson, 2012; and Bhidé, 2009.
23
See Greenspan, 2011.
24
See, e.g., Dagher and Fu, 2012. Against this idea, see, e.g., Tarr, 2010, pp. 21-23.
25
See Galbraith, 1993, p. 22.
26
See Howard, 2011. See also Lastra, 1996, pp. 143-144.
27
See Howard, 2011.
22
10
The fear of another financial crisis, although the current one is still unfolding,
has led lawmakers around the world to try to make the best possible rules to put
financial institutions back in the right path and to protect the financial system from
another turmoil. No situation should be left unattended. Every financial risk must be
chased and eliminated or, at least, controlled28.
Nevertheless, struggling to regulate all the situations that may lead to a financial
crisis will inevitably become a cat-and-mouse chase. As mentioned above, regulation is
a response to a perceived reality: rules will always come after facts. And given the
dynamics of the financial system, more and more rules will be needed every day and
more stacks of financial rules will be added, since no one today is in a position to
advocate rescinding them.
It seems that overregulation has been chosen as the right response to the recent
financial crisis and the Wall Street Reform and Consumer Protection Act (Dodd-Frank
act) is its archetype. With its 848 pages, only corporate lawyers may not complain about
its prolixity and complexity29, but there are many reasons for criticism in choosing the
path of complex and abundant regulation30.
Overregulation has significant costs not only to the private businesses regulated,
which will have to devote more time and money to compliance 31, but also to the
regulators and supervisors themselves, at least for two main reasons.
First, it has to be taken into account that more regulation eventually leads to an
additional burden for the supervisors. For every rule created, one more duty of
supervision will be added and one more potential violation appears32.
Of course financial oversight is more easily performed today with the aid of
technological tools, making on-site supervision an exceptional measure. But even the
most prepared and well-equipped supervisory authority will face a huge task. Since
there will be an extensive and complex array of rules to enforce, supervisors will face
28
See Howard, 2011.
For a very harsh opinion about the Dodd-Frank act, see Greenspan, 2011. On the other hand, in favor of
the Dodd-Frank act, although not without some criticism, see Davidoff, 2012.
30
See Haldane, 2012. A call for less complex regulation was recently made also by the World Bank,
although based on different reasons and directed mostly to developing nations (see World Bank, 2012).
Also advocating the need for simpler rules and for a “results-based regulation”, see Howard, 2011.
31
See Keating, 2011.
32
It is interesting to note that even the proposition of the regulations required by the Dodd-Frank act is
itself a burden for the supervisors. In September 2012, the Securities and Exchange Commission, for
instance, had finalized only about 30% of the Dodd-Frank rule mandates, and had “quietly removed
timing estimates from its list of pending Dodd-Frank mandates, largely because the estimates were rarely
accurate”. See Ackerman, 2012.
29
11
many hurdles to properly and timely assess the compliance with all relevant rules by the
financial institutions.
Hence, it is important to have a well-designed supervisory structure, with a
number of staff proportionate not only to the number of financial institutions under
supervision, but also to the number of rules that has to be enforced. Unless this
symmetry is properly accomplished, the sense of impunity may come as a result.
Having many and detailed rules, but not a close oversight, capable of timely
identifying even the minor violations, is almost as effective as having no rules at all.
Every infraction that goes unnoticed gives the impression that rules exist but are not
enforced, weakening the credibility of the supervisory authorities and eventually of the
financial regulation itself.
It is true that the risk of undetected violations, due mostly to the imbalance
between the number of potential violators and the number of supervisors, exists in any
regulated sector. It should not be a reason against regulating the sector in the first place.
But with too many rules to enforce, the job of supervisors gets excessively difficult,
increasing the risk of impunity.
Comparisons with criminal law on this matter, however, are inaccurate. Unlike
criminal law, that has simple and enduring rules regulating easily comprehensible
situations to almost every person, financial regulation deals with more complex and
intricate situations. It is not possible to compare a crime, which almost every person can
easily recognize and, if needed, call the police, with a violation of a financial rule,
which even the most prepared and seasoned supervisor may face difficulties to identify.
When it comes to financial regulation, a “zero tolerance” approach is not
feasible. No supervisory authority will ever have the means to identify and punish all
the infractions of a given rule. That is why the sense of impunity will be the most likely,
if not the first, consequence of overregulation.
The second reason for being critical towards overregulation has to do with the
aftermath of oversight. It has been overlooked that the job of supervisors does not end
with the confirmation of compliance with the rules or the identification of violations.
What will be the consequences if a financial institution fails to observe the regulation?
On the one hand, creating new rules without setting any negative consequence if
they are not observed is the same as declaring their ineffectiveness from the beginning.
Rules that demand a positive or negative behavior must be followed by a sanction, or
12
they tend to be discredited. It is not possible to count on the good will of the financial
institutions on that matter.
On the other hand, administrative sanction seems to be the natural consequence
to the violations of financial regulation, since criminalization should only be used to
preserve the most important values for society and to prevent and punish the most
serious violations (de minimis and ultima ratio principles33).
But a fine, the standard administrative sanction, may not be the right answer in
every case, mainly if the financial institution that fails to observe a given rule also faces
liquidity problems. In situations like these, a fine will only worsen the problem and may
generate negative consequences not only to the violator, but also, depending on the size
and relevance of the punished financial institution, to the entire financial system.
Once liquidity is a sensitive issue in the financial system, applying pecuniary
sanctions against financial institutions that violate regulations may do more harm than
good. The alternative is to stipulate sanctions imposing restrictions on business
activities. But even this type of administrative sanction may create negative economic
consequences to the punished institution, demanding a thoughtful decision from the
supervisors.
In short, punishing institutions that rely on solidity and trust to do their
businesses is always a defiant matter, mostly because the same power used to enforce
financial regulation may also contribute to damage the value that motivated the
regulation in the first place: financial stability.
As we have seen, creating a proper and effective financial regulation in order to
prevent financial crises is a difficult task. And even if all the right rules could be created
after all, the supervisors would face many difficulties to enforce them, let alone to
identify the related violations and to timely punish them without taking the violators
down or spreading collateral damages to the entire financial system.
For all these reasons, we think that the regulation of the financial system,
especially if the aim is to prevent financial crises, should be focused on dealing with the
consequences of the crises, not on trying to avoid their causes, although it may seem
counterintuitive at first sight.
33
See Ashworth, 2003, pp. 24-57, 66-69.
13
3. A possible solution: regulating the consequences of financial crises
First of all, let us be clear that we do not advise abandoning prudential rules
altogether or suggest that legislators should not make laws intended to avert financial
crises. What we propose is that more attention should be given to the consequences of
financial crises, not to their causes34.
We really believe that regulators should not worry too much about why the last
financial crisis happened. Instead, they should try to learn how to minimize the
consequences of a new crisis. Because it is not a matter of ‘if’ another crisis will
happen; it is just a matter of ‘when’ the next crisis will happen, as Galbraith showed35.
Although the facts that give rise to financial crises may differ from time to time,
increasing the difficulty to have effective prudential rules, their consequences are
always similar: huge losses, failure of institutions, systemic risk and large use of public
money. That is why it might be easier for regulators to understand the consequences of
financial crises and, therefore, to get prepared for them.
For us, more important than organizing the best possible prudential regulation is
having a solid and well-developed financial safety net36 with rules clearly stating the
consequences for the troubled institutions, for their executives and creditors, and even
for other financial institutions when a financial crisis comes. After all, it must be
remembered that simply letting a bank or another financial institution fail is not an
option37.
The main goal behind this proposition is to avoid as much as possible the use of
public money to solve financial crises, allowing the improvement of the financial safety
net without giving room for moral hazard to arise.
But there is another reason in favor of this proposition. Organizing a financial
safety net in order to be prepared for crises might be more objective and more
34
Also stressing the limitations of ex ante regulation and the importance of resolution systems, especially
to address systemic risk, see Levitin, 2011, pp. 461-480. Likewise, stating that more attention should be
paid to the distinction between ex ante regulation, aimed at preventing financial failure, and ex post
regulation, aimed at responding to that failure, see Anabtawi and Schwarcz, 2013.
35
In the foreword to the 1993 edition of his A Short History of Financial Euphoria, Galbraith states (p.
viii. See also p. 110): “Recurrent speculative insanity and the associated financial deprivation and larger
devastation are, I am persuaded, inherent in the system. Perhaps it is better that this be recognized and
accepted”.
36
Contrary to this option, see Ricks, 2012, particularly pp. 1331-1340. Instead, the author proposes an
alternative regulatory framework to address the instability of the market for money-claims, which he
regards as “the central problem for financial regulatory policy”.
37
See Krugman, 2010. See also Lastra, 1996, pp. 134-143; Levitin, 2011, pp. 483-487.
14
comprehensive than trying to ensure that banks – and only banks38 – observe required
capital and liquidity standards to be safe and sound, as Basel III rules intend39.
On the one hand, the very notions of capital and liquidity are disputable, making
it hard for regulators to accurately define capital and to set up what asset should be
taken as liquid, so that it could be accepted to fulfill the standards required, e.g., by
Basel III rules40.
On the other hand, either if it were possible to assure that all parts of the system,
all financial institutions – not just banks – are ready to face a financial downturn, that
would not guarantee that the system itself would be crises-proof41. Since contagion
always plays an important role in financial crises, it is not possible to face a systemic
threat by being individually prepared. The whole system must have its own mechanisms
of defense, especially to avoid panic and to control the spreading of problems. The chief
purpose of financial regulation, especially if the aim is to avoid financial crises, should
be enhancing the solidity of the financial system, not only of its institutions42.
The first step to strengthen the financial system is having an appropriate deposit
insurance scheme, mainly because its only existence might contribute to avoid the
spreading of distrust to the entire system or to an important part of it when an episode of
distress comes up43. Bank depositors must be the first creditors to be protected because
avoiding bank runs is crucial to limit the effects of a failure, since it sooth market
expectations by safeguarding the most precious financial system asset: its image.
38
See Levitin, 2011, pp. 469-472.
See Lastra, 1996, pp. 93-97; 181-195. In favor of the Basel III liquidity coverage ratio, see Eavis, 2012.
Against the Basel III rules, especially because of their supposed pernicious impact on the global
economy, see The Institute of International Finance, 2011. For a cost-benefit analysis of “risk-constraint
regulation, such as portfolio restrictions and capital requirements”, especially in relation to the
prevention of money-claim panics, see Ricks, 2012, pp. 1325-1330.
40
See Bank for International Settlements, 2012. The Report, especially in p. 6, is very critic towards the
implementation of key parts of the Basel III standards by the United States and the European Union,
precisely because they state a broad definition of capital and give too much room for banks to assess the
riskiness of their portfolios. Acknowledging the difficulties of computing risk sensitivity and leverage
ratio to apply the Basel III rules, see the interview given by Stephen Cecchetti, head of the monetary and
economic department of the BIS, to The Wall Street Journal on 30 Oct. 2012. Proposing an alternative to
Basel III rules on capital requirements, see Pandit, 2012. The then CEO of Citigroup advocated that
instead of setting capital requirements regulators “should create a ‘benchmark’ portfolio and require all
financial institutions, not just banks, to measure risk against that”.
41
See Brunnermeier et al, 2009, pp. 5-11.
42
Advocating that one of the main goals of the financial regulation should be “to ensure the stability of
the overall financial system”, see United States Government Accountability Office, 2009.
43
Similarly, advocating that “to avoid a run on euro-zone banks a EU-wide system of deposit insurance
needs to be created”, see Ferguson and Roubini, 2012.
39
15
There is no doubt that the deposit insurance scheme must be financed by the
financial industry. Besides, the related fund should also serve as a resolution fund,
helping to provide liquidity to financial institutions in distress and to deal with their
liquidation44.
With this intent, premiums should be levied on every financial institution that
becomes relevant to the system. As the last crisis showed, not only banks can be
systemically relevant45. Hence, if a financial institution, although not a bank, become
relevant it should also finance the deposit insurance and resolution fund as any bank
does.
The point in having institutions other than banks financing the deposit insurance
and resolution fund is allowing them to resort to the fund as any bank can do, even
allowing them to be bailed or rescued under extreme conditions46. In spite of that, only
bank depositors would remain protected, as it is today.
In addition to the deposit insurance scheme attached to a resolution fund,
internal solutions must be found to deal with a potential failure within the financial
system. Following this path, the troubled institution should be required either to
internally solve its problems or to organize its liquidation. A bail-in should be a valid
option in the former situation and the resolution plan, or “living wills”, a reasonable
alternative in the latter.
In a bail-in process, the supervisory authorities would have the legal authority
“to force banks to recapitalise from within, using private capital, not public money”,
thus dictating “the terms of a recapitalisation, subject to an agreed framework”47. The
process would necessarily involve assets write-down and debt restructuring, always
without previous deliberation of the board or the creditors of the institution.
Relying on more cooperation from the institution, there is the resolution plan or
living wills, whereby the institution itself outlines a plan for its liquidation, if needs
be48.
44
See Schoenmaker and Gros, 2012.
In fact, Levitin (2011, pp. 453-454) argues that even nonfinancial firms could be systemically relevant,
since it is difficult to draw the financial/nonfinancial line in some cases.
46
Against the idea that the safety net should be available for financial institutions other than banks, see
Frost, 2012.
47
Calello and Wilson, 2010. See also Zhou et al, 2012.
48
See Lacker and Stern, 2012; Goodhart, 2010.
45
16
In any case, there must be explicit rules giving the supervisory authorities
specific powers to act in a bail-in process and to require relevant institutions to submit
resolution plans, especially to avoid challenges on the grounds of excessive discretion
or arbitrariness.
Both measures seem to be valid attempts to cope with too-big-to-fail
institutions49 and to have more predictable and organized ways to deal with and even to
liquidate troubled institutions during times of financial distress50, although criticism still
subsists51.
In the process of trying to solve the problems of a troubled financial institution
and to avert the possibility of a crisis, the supervisory authorities should also have the
legal power to search for a solution within the financial system. With this aim, the
supervisors should have the power not only to seek for a consensual market solution,
but also to impose one.
Since financial institutions are the first to benefit from a stable financial system,
free from institutions that may spread risk and distrust, they should take part in the
process of fixing the problems of any troubled financial institution.
Of course supervisory authorities’ first step to reach a market solution should be
finding another financial institution interested in taking over a part of or all the
businesses, assets and creditors of the troubled institution. But if no financial institution
shows interest, the supervisory authorities should have the power to determine the
mandatory transference of assets and liabilities from the institution under distress to one
or more financial institutions.
Giving the supervisory authorities power to issue even a mandatory market
solution to deal with a troubled financial institution is positive not only because it
clearly states that everything will be done to find a private solution instead of a public
one when it comes to failure in the financial system, but also because it makes all
financial institutions responsible for the future of one another.
49
There is also a more radical proposition advocating that too-big-to-fail institutions should not exist in
the first place, and therefore demanding to break them up. See, e.g., Johnson, 2012; Jenkins, 2012.
Breaking up big institutions, however, might neither be an easy task nor an effective solution: see Zweig,
2012; and Rattner, 2012. To an outright defense of “big banks”, see Harrison Jr., 2012.
50
With these aims, although not with the cooperation of the troubled institution, it could also be referred
the “single receivership” resolution approach proposed by the Federal Deposit Insurance Corporation
(FDIC), explained and praised by Krimminger, 2012. Criticizing the FDIC’s “single receivership”
approach, see Miller and Horwitz, 2012.
51
See Levitin, 2011, pp. 467-469; Silver-Greenberg and Schwartz, 2012.
17
This measure could encourage cross-oversight and whistle-blowing among
financial institutions, bringing to the supervisory authorities information that they
would not have otherwise. Nobody knows the market better than the market itself. So,
the mandatory market solution could be a valid attempt to make the market speak, even
if only to avoid paying for the errors and faults of others.
But if the deposit insurance and resolution fund, the co-participation of the
troubled institutions and even the participation of other financial institutions are
insufficient to stem the problems and to control contagion within the financial system, it
is almost certain that public money will have to be used to prevent a financial crisis
from beginning or intensifying. This should be the moment to summon the executives52
of the failed financial institutions: if they were part of the problem, they should also be
part of the solution53.
That is why we think financial institution executives must prepare professional
“living wills”, to be used if the deposit insurance and resolution fund, the bail-in
process, the institutional living wills and the market solution are not enough to avoid the
use of taxpayers’ money to pay for the losses the failed institution has caused.
By preparing professional “living wills”, financial institution executives would
be forced to keep some amount of spare liquid assets to help covering future losses
caused by the institution for which they work. This amount should be determined by a
fraction of the total amount of payments they receive from the institution in a given
time. Thus, the bigger the payments, the bigger the needed amount of spare assets, if not
for other reasons, at least to discourage the payment of artificially inflated bonuses.
Hence, one sole condition should exist to trigger the implementation of the
professional “living wills”: the use of taxpayers’ money to liquidate or to bail out the
financial institution. Note that it should be a case not only of personal liability, but also
of strict or absolute liability, since the executives should be held responsible regardless
of any proof of fault54.
52
“Executives” in the article refers to the highest-level managers of the financial institutions, like chief
officers (“C-level executives”) and members of executive or management boards, and does not include
members of the board of directors or other supervisory boards, which generally are not in charge of
management duties or day-to-day operations.
53
Voicing the frustration of not seeing any major banking executive pay any price in the aftermath of the
last financial crisis, see Eisinger, 2012; and Cohan, 2012. See also Tett, 2009.
54
It is necessary to stress that we are not talking about fraud on this matter. Fraud should be investigated
and punished in the ambit of criminal justice.
18
Anyway, two limits should be set concerning the liability of the failed institution
executives. First, only the assets detached in accordance with the stipulations of the
professional “living wills” would be expropriated, regardless of the total amount of
public money used. The intention is that executives are forced to take part in the process
of failure of the financial institution, not that they lose all the money they have received
from the failed institution, which could be challenged as illegal or even
unconstitutional, nor that they personally pay for all the outstanding losses, which
would not be feasible.
Second, there should be a time limit for this kind of responsibility. Only
executives that worked for the failed institution in a determined period before the failure
– 10 years, for instance – should be held responsible. Again, the intention is to summon
the executives that might have contributed to the failure of the institution, not to keep all
the former executives indefinitely under a legal threat.
Furthermore, clearly stating that executives could be responsible for the losses
caused by the failed financial institution might create enough incentive to persuade
them to avoid reckless risk-taking. As their private property becomes subject to the
consequences of a failure, executives might give more attention not only to strategies
intended to increase profits, but also to strategies designed to limit or control risks. Risk
assessment inside the financial system might finally be taken more seriously.
As we have seen, regulating the consequences of financial crises is, in the first
place, trying to find solutions to the financial system problems from within, thus
avoiding the use of public money to save financial institutions or even the system itself.
It is important that the regulation sends the message that taxpayers’ money will only be
used as the last resort, if all the other solutions fail and if systemic risk exists55.
Nonetheless, there will be crises in which the use of public money will become
inevitable, no matter what previous measures are taken to avoid or to soften the crisis56.
Hence, a final issue must be discussed herein: should the amount of public money that
could be used to cope with serious financial crises also be a regulated matter? We do
not think so.
55
Critically assessing the definitions of systemic risk, with a personal proposal in the end, see Levitin,
2011, pp. 443-451.
56
Also stating the inevitability of bailouts, see Levitin, 2011, p. 490.
19
It would be difficult to previously define limits on the use of public money in a
financial crisis, not to say to forbid the use of public money in a situation like that57,
something not realistic58. As remarked above, it is possible to create legal mechanisms
in order to avoid or to mitigate the use of public money to save the financial system, but
once it is needed, it is hard to put a limit on it, since it is difficult to foresee the depth of
a financial crisis.
4. Conclusion
In this paper we suggest that regulating the financial system, especially with the
aim of preventing crises, might be more a matter of dealing with the consequences that
emerge from a financial crisis than a matter of trying to avoid the causes that may lead
to it.
The natural instability and the dynamics of the financial system combined with
the inherent limits of the process of creating rules give strong reasons to be pessimistic
about the effectiveness of the regulation intended to prevent the causes of financial
crises.
As we have seen, regulation is a response to a perceived reality: rules will
always come after facts. Hence, financial rules are thought and created taking into
consideration a reality that existed one day, but may not exist anymore. It is hard for
financial regulation to catch up with financial innovation.
Trying to solve these problems by regulating all situations that may lead to a
financial crisis will inevitably breed overregulation, which does not seem to be a good
legal response either.
The increasing number of rules will overwhelm the supervisory authorities with
work. They will have not only to properly assess if the institutions subject to the
regulation observe all relevant rules, but also to identify the related violations and to
timely punish violators without taking them down or spreading collateral damages to
the financial system, since liquidity and stability are always sensitive matters in the
financial sectors.
57
58
See, e.g., McConnell, 2010.
See Ricks, 2012, pp. 1331.
20
For all these reasons, we believe that more important than organizing the best
possible prudential regulation is having a solid and well-developed financial safety net.
This could be done by answering at least three main questions: (a) how to organize a
deposit insurance and resolution fund to be used as the first response to a problem in the
financial system; (b) how to find a private solution instead of a public one when it
comes to deal with failure in the financial system; and, very important, particularly to
reduce the moral hazard that may follow the safety net, (c) how to hold executives
personally liable for the losses caused by failed financial institutions.
Properly answering these questions and creating a legal framework directed to
minimize the consequences of financial crises seem to be the more suitable, if not the
only effective, legal response when it comes to financial regulation.
It is worth noting that the legal option herein proposed, apart from being a valid
attempt to overcome prudential regulation limitations, has also advantages of its own.
First, because governmental interference in economic affairs should be
exceptional, not usual. Financial markets should be essentially free and financial
institutions should perform their business under minimum intervention. But in times of
distress, when the financial system fails to properly handle the problems itself creates,
freedom must be replaced by interventionism, especially if the use of public money is
inevitable to cope with the crisis. In this case, the supervisory authorities should have
the legal power to dictate the way to solve the problems and even to impose mandatory
solutions against the will or the best interest – at least in the short term – of financial
institutions and of their executives, shareholders and creditors.
Second, because unlike the causes of financial crises, which often have different
triggers, their consequences tend to be similar, giving regulators more time to
understand them and, therefore, to be prepared for them, making it easier to create
appropriate and effective regulation.
Third, because building a strong safety net might not only boost confidence in
the financial system and contribute to its stability, but also create the right incentives to
avoid reckless risk-taking, mainly if there are rules establishing that other financial
institutions and even executives could be held responsible for the trouble caused by any
failed financial institution.
Having rules clearly stating the consequences for the troubled institution, for its
executives and even for other financial institutions when a financial crisis comes might
21
also increase the effectiveness of prudential regulation itself. Since all financial
institutions and its executives become responsible for each failure in the financial
system, everybody will have more interest in observing capital and liquidity standards,
in creating debt more wisely and in properly assessing risk taking. It might be a matter
of inverted incentives.
Forth, because although the solutions proposed in this paper are national
oriented, their implementation might generate international repercussion. On the one
hand, the more the countries are prepared for the aftermath of financial crises, the
milder will be the impact of the failure of a cross-border institution. Besides, there will
be less incentive to engage in regulatory arbitrage, since, no matter the differences
among prudential regulations around the world, in the end the legal consequences for
troubled institutions will be the same or at least similar in any country. After all, it has
to be taken into account that although global financial institutions are international in
life, they tend to be national in death59.
On the other hand, it is difficult to think of any effective transnational solution in
the ambit of financial regulation without the creation of a transnational rule-maker or, at
least, of a transnational supervisory authority, something that does not seem to be
practicable anytime soon, if ever60.
In short, regulating the consequences of financial crises might be the best legal
option even to have a more effective prudential regulation61, which eventually will help
to prevent the very causes of financial crises.
59
See Goodhart, 2010, p. 182. See also Shirakawa, 2009.
See Embid Irujo, 2009, p. 119.
61
See Levitin, 2011, p. 480.
60
22
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297 Avaliando a Volatilidade Diária dos Ativos:
a hora da negociação importa?
José Valentim Machado Vicente, Gustavo Silva Araújo,
Paula Baião Fisher de Castro e Felipe Noronha Tavares
Nov/2012
298 Atuação de Bancos Estrangeiros no Brasil:
mercado de crédito e de derivativos de 2005 a 2011
Raquel de Freitas Oliveira, Rafael Felipe Schiozer e Sérgio Leão
Nov/2012
299 Local Market Structure and Bank Competition: evidence from the
Brazilian auto loan market
Bruno Martins
Nov/2012
299 Estrutura de Mercado Local e Competição Bancária: evidências no
mercado de financiamento de veículos
Bruno Martins
Nov/2012
300 Conectividade e Risco Sistêmico no Sistema de Pagamentos Brasileiro
Benjamin Miranda Tabak, Rodrigo César de Castro Miranda e
Sergio Rubens Stancato de Souza
Nov/2012
300 Connectivity and Systemic Risk in the Brazilian
National Payments System
Benjamin Miranda Tabak, Rodrigo César de Castro Miranda and
Sergio Rubens Stancato de Souza
Nov/2012
301 Determinantes da Captação Líquida dos Depósitos de Poupança
Clodoaldo Aparecido Annibal
Dez/2012
302 Stress Testing Liquidity Risk: the case of the Brazilian Banking System
Benjamin M. Tabak, Solange M. Guerra, Rodrigo C. Miranda and Sergio
Rubens S. de Souza
Dec/2012
303 Using a DSGE Model to Assess the
Macroeconomic Effects of Reserve Requirements in Brazil
Waldyr Dutra Areosa and Christiano Arrigoni Coelho
Jan/2013
303 Utilizando um Modelo DSGE para
Avaliar os Efeitos Macroeconômicos dos
Recolhimentos Compulsórios no Brasil
Waldyr Dutra Areosa e Christiano Arrigoni Coelho
Jan/2013
304 Credit Default and Business Cycles:
an investigation of this relationship in
the Brazilian corporate credit market
Jaqueline Terra Moura Marins and Myrian Beatriz Eiras das Neves
29
Mar/2013
304 Inadimplência de Crédito e Ciclo Econômico:
um exame da relação no mercado brasileiro
de crédito corporativo
Jaqueline Terra Moura Marins e Myrian Beatriz Eiras das Neves
Mar/2013
305 Preços Administrados: projeção e repasse cambial
Paulo Roberto de Sampaio Alves, Francisco Marcos Rodrigues Figueiredo,
Antonio Negromonte Nascimento Junior e Leonardo Pio Perez
Mar/2013
306 Complex Networks and Banking Systems Supervision
Theophilos Papadimitriou, Periklis Gogas and Benjamin M. Tabak
May/2013
306 Redes Complexas e Supervisão de Sistemas Bancários
Theophilos Papadimitriou, Periklis Gogas e Benjamin M. Tabak
Maio/2013
307 Risco Sistêmico no Mercado Bancário Brasileiro – Uma abordagem pelo
método CoVaR
Gustavo Silva Araújo e Sérgio Leão
Jul/2013
308 Transmissão da Política Monetária pelos Canais de Tomada de Risco e
de Crédito: uma análise considerando os seguros contratados pelos
bancos e o spread de crédito no Brasil
Debora Pereira Tavares, Gabriel Caldas Montes e Osmani Teixeira de
Carvalho Guillén
Jul/2013
309 Converting the NPL Ratio into a Comparable Long Term Metric
Rodrigo Lara Pinto Coelho and Gilneu Francisco Astolfi Vivan
Jul/2013
310 Banks, Asset Management or Consultancies’ Inflation Forecasts: is there
a better forecaster out there?
Tito Nícias Teixeira da Silva Filho
Jul/2013
311 Estimação não-paramétrica do risco de cauda
Caio Ibsen Rodrigues Almeida, José Valentim Machado Vicente e
Osmani Teixeira de Carvalho Guillen
Jul/2013
312 A Influência da Assimetria de Informação no Retorno e na Volatilidade
das Carteiras de Ações de Valor e de Crescimento
Max Leandro Ferreira Tavares, Claudio Henrique da Silveira Barbedo e
Gustavo Silva Araújo
Jul/2013
313 Quantitative Easing and Related Capital Flows
into Brazil: measuring its effects and transmission
channels through a rigorous counterfactual evaluation
João Barata R. B. Barroso, Luiz A. Pereira da Silva and
Adriana Soares Sales
Jul/2013
314 Long-Run Determinants of
the Brazilian Real: a closer look at commodities
Emanuel Kohlscheen
Jul/2013
315 Price Differentiation and Menu Costs in Credit Card Payments
Marcos Valli Jorge and Wilfredo Leiva Maldonado
Jul/2013
315 Diferenciação de Preços e Custos de Menu nos Pagamentos com
Cartão de Crédito
Marcos Valli Jorge e Wilfredo Leiva Maldonado
Jul/2013
30
316 Política Monetária e Assimetria de Informação: um estudo a partir do
mercado futuro de taxas de juros no Brasil
Gustavo Araújo, Bruno Vieira Carvalho, Claudio Henrique Barbedo e
Margarida Maria Gutierrez
Jul/2013
317 Official Interventions through Derivatives: affecting the demand for
foreign exchange
Emanuel Kohlscheen and Sandro C. Andrade
Jul/2013
318 Assessing Systemic Risk in the Brazilian Interbank Market
Benjamin M. Tabak, Sergio R. S. Souza and Solange M. Guerra
Jul/2013
319 Contabilização da Cédula de Produto Rural à Luz da sua Essência
Cássio Roberto Leite Netto
Jul/2013
320 Insolvency and Contagion in the Brazilian Interbank Market
Sergio R. S. Souza, Benjamin M. Tabak and Solange M. Guerra
Aug/2013
321 Systemic Risk Measures
Solange Maria Guerra, Benjamin Miranda Tabak, Rodrigo Andrés de Souza
Penaloza and Rodrigo César de Castro Miranda
Aug/2013
322 Contagion Risk within Firm-Bank Bivariate Networks
Rodrigo César de Castro Miranda and Benjamin Miranda Tabak
Aug/2013
323 Loan Pricing Following a Macro Prudential
Within-Sector Capital Measure
Bruno Martins and Ricardo Schechtman
Aug/2013
324 Inflation Targeting and Financial Stability:
A Perspective from the Developing World
Pierre-Richard Agénor and Luiz A. Pereira da Silva
Sep/2013
325 Teste da Hipótese de Mercados Adaptativos para o Brasil
Glener de Almeida Dourado e Benjamin Miranda Tabak
Set/2013
326 Existência de equilíbrio num jogo com bancarrota e agentes
heterogêneos
Solange Maria Guerra, Rodrigo Andrés de Souza Peñaloza e Benjamin
Miranda Tabak
Out/2013
327 Celeridade do Sistema Judiciário e Créditos Bancários para as
Indústrias de Transformação
Jacopo Ponticelli e Leonardo S. Alencar
Out/2013
328 Mercados Financeiros Globais – Uma Análise da Interconectividade
Marcius Correia Lima Filho, Rodrigo Cesar de Castro Miranda e
Benjamin Miranda Tabak
Out/2013
329 Is the Divine Coincidence Just a Coincidence? The Implications of Trend
Inflation
Sergio A. Lago Alves
Oct/2013
330 Forecasting Multivariate Time Series under Present-Value-Model
Short- and Long-run Co-movement Restrictions
Osmani Teixeira de Carvalho Guillén, Alain Hecq, João Victor Issler and
Diogo Saraiva
Oct/2013
331 Measuring Inflation Persistence in Brazil Using a Multivariate Model
Vicente da Gama Machado and Marcelo Savino Portugal
Nov/2013
31
332 Does trade shrink the measure of domestic firms?
João Barata R. B. Barroso
Nov/2013
333 Do Capital Buffers Matter? A Study on the Profitability and Funding
Costs Determinants of the Brazilian Banking System
Benjamin Miranda Tabak, Denise Leyi Li, João V. L. de Vasconcelos and
Daniel O. Cajueiro
Nov/2013
334 Análise do Comportamento dos Bancos Brasileiros Pré e Pós-Crise
Subprime
Osmani Teixeira de Carvalho Guillén, José Valentim Machado Vicente e
Claudio Oliveira de Moraes
Nov/2013
32
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